Blockchain technology is touted to transform financial markets. Andrew Dykes explores what the impact might be on the energy sector, both in commodities markets and the field
You can’t go anywhere without hearing about it these days. No industry is safe, no task too complex. Blockchain has threatened to shake up financial markets and, increasingly, hopefuls are seeking new homes for the technology, including the oil and gas sector. Most obviously, blockchain can simplify commodity contracts but there is scope for improvements in how the industry handles logistics and inventories.
The blockchain is based on the same principles that underpin the world’s most well-known cryptocurrency, Bitcoin. Blockchain algorithms are a method of encoding peer-to-peer transactions. These transactions are recorded and stored together in a timestamped “block” of data, which is then logged and stored in a decentralised database. When created, each block is assigned a unique algorithmic hash code based on the information it contains, as well as the block before it (chaining them together).
If any piece of transaction data does not match the block, the verification algorithm will not produce the correct hash code, and will flag an error. This process allows transactions to be continuously stored and verified by the parties using the system, and more blocks added to the chain, but the transaction cannot be revised. The network of “distributed ledgers” also ensures that all participants in the contract or transaction use the same, correct information.
The Big Four accounting firms – KPMG, PwC, Deloitte and EY – in particular have come out swinging, with banks following suit. According to a 2016 IBM survey, 15% of global banks intend to roll out full-scale commercial blockchain products in 2017 – an uptake it said was “dramatically faster” than anticipated, and light years ahead of the 5-10 years expected by many in the industry.
The benefits of such a system are said to be increased digital security, data transparency, the removal of duplication and better automation, which are all worthy outcomes. One would be forgiven, though, for questioning where these technologies may fit into the energy industry. Yet, if the hype is to be believed, energy and its associated businesses are ripe for a blockchain-based transformation.
Block party The main scope for blockchain in the energy sector lies in the simplification of contracting and commodity trading. “Blockchain has increasing relevance to the oil and gas industry as a mechanism to reduce operating cost. Even more relevant, however, is [its] ability to transform the contracting process given its aptitude to provide a secure form of collaboration across multiple parties” EY oil & gas strategy leader Fay Shong recently stated. The creation of smarter, blockchain-based contracts can streamline and automate large portions of the trading process. PwC has highlighted the lengthy process of confirmations, actualisation of volumes and the numerous forms of reconciliation that may follow a trade. All of these require costly and time-consuming work in the back offices of traders, banks, and clearing houses – in some cases by up to a dozen parties. Much of the system’s benefits – as far as banks and accountants see it – is in removing these intermediaries altogether. "Rather than each post-trade participant maintaining the same data in their individual ledgers, a master ledger shared among those participants would eliminate the need for costly reconciliation processes," Moody's SVP Robard Williams commented in a recent note.
Smart contracts do also bring other niche advantages, such as the ability to execute a trade only once certain parameters have been met, e.g. a certain price threshold or only once a slot become available at a cargo-loading destination. IBM suggested that: “If import terminals received data from bills of lading earlier in the process, terminals could plan and execute more efficiently and without privacy concerns. Blockchain technology could make appropriate data visible in near real-time – for example, the departure time and weight of containers – while making inaccessible the information about the owners and value of the cargo.”
PwC notes that such contracts “allow seamless tracking of ownership … coupled with the ability to verify data at both ends.” In the case of an oil cargo, for example, it would ensure that funds are transferred to the seller once the quantity and quality of that cargo has been confirmed.
Experiments in the electricity trading sector are already in progress, and commodity traders are beginning to catch on. Most recently, ING and Société Générale Corporate & Investment Banking concluded the first oil trade using a prototype blockchain platform. During London’s IP Week, both groups demonstrated a live trade with trading house Mercuria.
The system, dubbed “Easy Trading Connect,” was created to offer a standardised, digital and paperless trading system. The experiment involved an oil cargo shipment containing African crude, which was sold three times on its way to China. The demonstration included traders, banks, an agent and an inspector, all of whom interacted with the transaction directly via the platform.
At its most basic, the technology simplifies the means of certifying and recording the documents and the sale of goods, but the implications are significant. According to ING, the platform reduced the average total time for a bank to complete its role in the transaction from approximately three hours to 25 minutes. Replicated over hundreds of trades, that frees up considerable staff time and could lower the amount of capital required by traders to cover the cost of oil in transit.
ING Trade & Commodity Finance director Patrick Arnaud added: “The commodity finance industry is hampered by nature by inefficiencies and outdated procedures. By applying blockchain technology, we expect that we can eliminate a lot of these, making the overall process faster and more cost effective and the tests we have been able to carry out have proved this.”
Unchained potential However, it is not just downstream trading that technologists are targeting. Upstream, PwC sees potential to apply these systems to asset management and service contracts. Using the smart contract model “owners can be informed of production volumes in real time and compensated by working interest as soon as the drilled commodity is priced and sold,” the group noted.
That extends to midstream infrastructure, such as pipelines, where throughput can be monitored in real time, compared against expected volume and transactions can then be initiated once each participant has verified. In addition, blockchain architecture could help solve issues around secure upstream data storage, EY believes. “As the oil and gas industry increasingly leverages sensor technology across upstream and downstream assets, the ability for blockchain to store transactions and accounting data directly on these devices can compress process time by connecting assets directly to services contracts,” Shong explains.
The supply chain is ripe for simplification too. While various logistics and tracking systems are used for shipping oilfield equipment, many are not linked directly to contract fulfilment and payment. The smart contract model for commodity trades could be applied to the provision of services, enabling payment once the equipment reaches its destination, or the service contract has been initiated.
While promising, some of these particular applications have the hallmarks of over-complexity. Certainly, real-time asset monitoring and connected technologies are transforming how operators, service providers and OEMs look at their business. But many versions of these systems already exist in internal networks. In external transactions, whether for security or out of habit, many oilfield companies are likely to remain with the status quo.
Weak links Successful use of blockchain technology requires a number of things to happen. In particular, as the CFO of global trading house Trafigura, Christophe Salmon, recently remarked to the FT, the technology must be adopted broadly. The majority of major traders and oil refiners would need to take up to such a system in order to make the platform viable.
That network would need to be scaled far beyond the size of trials used at present. Moreover, as many have pointed out, the necessity of being able to trade with as any partners as possible would likely result in a trend towards a single blockchain platform. That platform would either be public (too transparent and open for many traders) or private (and potentially anti-competitive).
Regulators must also catch up. EY, for example, questions how cross-border payments should be taxed given that these would be instantaneously routed through machines across the world. More legislation on data security and ownership will be necessary too, to establish best practices and determine who is responsible in the event of a breach.
Large swathes of the trading business are affected by this potential disruption, with some facing an existential battle should the technology gain ground. It may, though, be better to regard blockchain as evolutionary, rather than revolutionary.
“Existing clearing and settlement incumbents will remain largely in place,” Moody’s said. “Innovative incumbents are already making large investments in blockchain technology and are collaborating with one another, as well as with start-up companies to create sector-wide solutions.” Meanwhile, the savings offered by the adoption of smarter, digital contracts would reduce reconciliation costs and “help offset lower revenues that custodians, clearing houses and/or registrars might suffer” as a result of faster settlement.
Certainly we are about to see an influx of these “innovative incumbents.” The trading market in particular will look very different in just a few short years as these systems, or systems very like them, help to automate labour-intensive and paperwork-heavy procedures. But elsewhere, the widespread adoption of the technology will depend on how far its benefits can be communicated to notoriously conservative oil executives – and that may be a harder sell in a market which is rarely the first to welcome new kids on the block.